MA922: Actuarial Risk Management 2 ( May 2016)

MA922: Actuarial Risk Management 2 May 2016

1
(a) To cover risks
A general insurance company needs to have capital to cover the risks of adverse
experience.
Adverse experience may reduce the value of the assets in relation to the liabilities
and the insurance company needs capital to have a high probability of remaining
solvent.
The risks include asset risks, liability risks, liquidity risks and operational risks.
There is risk of a major event occurring, including an insurance catastrophe (such as
a hurricane, earthquake or flooding) and a major financial crisis (eg the 2008 credit
crisis). These can affect the assets and liabilities of the company.
Cover new business strain
A viable general insurance company needs to have capital to finance new business.
New business incurs development costs and other initial costs including commission
and initial administration costs. New business results in an initial valuation loss to the
company, which is expected to be recovered from future profits. Without capital, a
company would be unable to expand its business.
Statutory minimum solvency margin
There may be a statutory minimum solvency margin required by regulations. The
general insurance company needs to have enough capital to comply with the
regulations.
Regulators usually require a statutory minimum solvency margin to reduce systemic
risk, because an insolvent insurance company could damage the economy.
Consumer confidence
A general insurance company needs capital so that customers, sales intermediaries
and investors can have confidence in the security of the business. Without sufficient
capital, customers are less likely to buy insurance from the company and sales
intermediaries are less likely to recommend the company to their clients (unless they
are tied agents).
Credit rating
A general insurance company may hold capital to improve its credit rating. This helps
to increase consumer confidence in the company and helps the company to borrow
at lower rates of interest.
Smooth reported profits

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MA922: Actuarial Risk Management 2 ( May 2016)

The general insurance company may use a claims equalisation reserve to smooth
profits. The claims equalisation reserve is increased after a profitable year and
reduced after an unprofitable year.
Invest more freely
Additional capital allows a general insurance company to invest in a higher
proportion of equities or property which may provide a higher expected return than
matching assets (usually short term assets).
[1 per point max 7]
(b) The general insurance company will assess how much capital it needs for the
various reasons discussed in (a), including sufficient capital to cover the statutory
minimum solvency margin. This amount of capital is the economic capital.
If the statutory minimum solvency margin is on a prudent basis, it may be sufficient
for most of the purposes in (a).
If the statutory minimum solvency margin is on a weak basis, the company may wish
to hold significant extra capital for the other purposes in (a). In particular, the
company will want to hold sufficient capital to remain solvent at a probability
acceptable to the various stakeholders. These include the policyholders, the
shareholders, the sales intermediaries, the regulator and the company directors.
The company would want to hold capital in excess of the statutory minimum
solvency margin in any case, even if the statutory minimum solvency margin is on a
prudent basis, to reduce the probability of falling below the statutory minimum. This
would lead to intervention by the regulator which may be damaging to the company.
The directors of the company may not wish to hold excessive capital because this
tends to reduce the return on capital for investors. The directors may be influenced
by the amount of capital held in excess of the statutory minimum by other insurance
companies. [1 per point max 5]
(c)
Reduce new business
The company could reduce the amount new business it takes on or reduce marketing
costs. This would reduce new business strain and may help to improve the statutory
minimum solvency margin. But it also reduces the potential profitability in the future.
The company may be able to improve its capital position by closing one or more lines
of business, which are highly risky and have a high capital requirement.
Reinsurance
The company may be able to use more reinsurance to improve its capital position. It
could use excess loss reinsurance to reduce its insurance risks, which may help to
reduce its capital requirement. It may use quota share of financial reinsurance to
reduce its new business strain. But using more reinsurance tends to reduce
profitability.

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MA922: Actuarial Risk Management 2 ( May 2016)

Issue shares
The company may issue shares to investors by a rights issue. This would improve the
capital position but is not usually popular with shareholders and may affect the share
price.
Reduce dividends
The company may improve the capital position by reducing dividends. Again this
would not be popular with shareholders.
Invest in safer assets
The company may be able to reduce its asset risks by investing in safer assets or
assets which more closely match its liabilities. This may help to reduce the capital
requirement.
Securitisation
The company may be able to improve its capital position by securitising one or more
of its lines of business. The cash flows of the lines of business are converted to a
security through a special purpose vehicle. The company receives a payment from
investors and the investors take on the risks of the business which has been
securitised. But this reduces the expected future profitability of the company.
[1 per point max 5]

[Total 17]

(a) The main stakeholders in the scheme include the company sponsor, the scheme
trustees, the scheme members and the regulator (if there is one).
The company sponsor has made a benefit promise to members, which may have the
force of a guarantee depending on legislation, and is paying for the cost of the
scheme. The company will be subject to financial constraints.
The choice of valuation assumptions affects the contribution rate paid to the scheme
and will affect the funding level in the future. If the valuation assumptions are
prudent, the calculated contribution rate will be higher and will increase the funding
level in the future.
The company sponsor may want the valuation assumptions to be realistic rather than
prudent, so that the calculated contribution rate will be lower.
Prudent assumptions will increase the opportunity cost for the sponsor. If a large
surplus accumulates, it may lead to demands to distribute the surplus to the scheme
members, which would increase the cost for the company.
A main concern of the scheme trustees and members is that the members’ benefits
are secure. A higher funding level increases the security of the benefits. The trustees
and members may prefer the valuation assumptions to be prudent to increase the
funding level in the future.

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The active members will be concerned about the security of the company. It would
not be in their interests for the company to pay excessive contributions if this
weakens the company financially. Furthermore, if prudent assumptions are used, the
company may decide to reduce the benefits for future service. This may not be in
the active members’ interests.
The regulator, if there is one, would be concerned that the scheme complies with
any funding regulations. There may be regulations specifying a maximum or
minimum funding level. [5]
(b)
In general, for all of the assumptions, the actuary will use the assumptions at the
last valuation as a starting point. The actuary may decide to use the same
assumptions as before, unless there are reasons to change some of them.
The actuary may compare the assumptions used at the last valuation date with the
experience since then, to find out any significant differences.
Rate of salary increase
This will depend on earnings inflation and possible promotional increases.
The actuary may obtain information from the company about promotional increases
and ask the senior managers how the company’s salary increases are expected to
compare with price or earnings inflation in the future.
The earnings inflation assumption will be related to the interest rate assumption and
depends on how prudent the actuary decides to be. The difference between the
interest rate and earnings inflation assumption might be in the range 1 to 4% pa.
Early leavers’ decrements
The actuary may investigate the decrements since the last valuation and derive
decrement rates based on the experience.
The actuary may have external data on decrement rates from other companies. This
provides a larger source of data, though it is less relevant than the company’s own
data.
The choice of decrements depends on how prudent the actuary wishes to be. The
most prudent assumptions would be to assume there are no early leavers’
decrements, as the early leavers’ benefits are frozen at date of leaving.
Mortality before and after retirement
The actuary may investigate the scheme mortality rates since the last valuation (or
over a longer period) and derive mortality rates based on the experience. The
scheme data will not have sufficient credibility by itself and the actuary will want to
use a standard mortality table from external sources.
The actuary may use standard mortality tables for assured lives or annuitants (if
available) with allowance for future mortality improvements and the difference
between the company’s experience and the standard mortality rates.

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The choice of mortality rates may depend on the nature of the business carried out
by the company and the nature of the work of the employees.
The choice of assumptions depends on how prudent the actuary wishes to be. A
prudent assumption would be to use low mortality rates with allowance for
significant improvements in the future. [8]
(c)
Contribution rate for future service
= value of future benefits accrued over the next 20 years for active members
value of future salaries for all active members over the next 20 years
= 650 = 14.44% of salary
4500 [1]
Value of deficit = value of assets – value of past service liabilities
= 400 m – 500 m
= -100m [1]
An extra contribution rate is needed to make up the deficit. This depends on how the
deficit is spread. [1]
If it is spread over 20 years as a percentage of salary, the extra contribution rate is:
100 = 2.22% of salary
4500
The overall contribution rate would then be 14.44 + 2.22 = 16.66% [1]
The deficit could alternatively be made up over a shorter period, giving a higher
contribution rate. [1]
In practice, the actuary would consider the existing contribution rates when deciding
the contribution rate to recommend. [1]
[Overall 4]

(d ) (1) Three views of solvency

 Cash flow solvency : the ability of the company or fund to meet its
obligations as they fall due
 Discontinuance solvency : if the company or fund ceased to be
active, the adequacy of its existing assets to cover its obligations
 Going concern solvency : the ability of the fund or company to meet
its future obligation if it follows its ongoing business plan
[3]
(d ) (ii) For this pension fund
 Pensions in payment is the main outflow and the assets, which
have been calculated at market value may be assumed to be
realizable, to cover any cash flows for many years to come. Cash
flow solvency is not a problem.
 In the context of the pension fund, discontinuance would be the

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MA922: Actuarial Risk Management 2 ( May 2016)

closure of the funds to new money. The liability would be for past
service beneifts and the assets are inadequate to cover that.
Discontinuance solvency is not present, i.e. the fund is insolvent on
a discontinuance basis.
 Provided the company accepts the funding basis recommended by
the actuary the assets and the liabilities will balance. The fund is
solvent on the going concern basis.

[3]

[Total 23]

Question 3

(a) There is a wide universe of risks that can affect any company – the
ultimate effects being felt in the profits and balance sheet of the entire
enterprise. Management ast the enterprise level ensures there is
consistent identification and management of these risks and
consequent efficiency.
[2]

(b) The three viable alternatives are:

a. The company chairman – ensuring monitoring independent of
the conflicts of interest with the executive
b. The company chief executive – ensuring access to the individual
who can best ensure necessary actions are taken
c. The company chief financial officer – as companies are primarily
concerned with the financial effects of risk
My preference is for the CEO – for the reason shown.
[3]
(The least acceptable is the CFO whose interests are conflicted; it would be an unusual
chairman that did not pass the buck in practice back to the CEO but I can accept either
for some marks if well presented))

Question 4

The easy answers having been closed off by the pig headedness of the
shareholders, two alternatives might be:

 Galaxy is unlikely to be unique in this problem. It should explore the

possibility of setting up with other insurers a worldwide pool for
excess losses and coverage needs. This is currently the approach
used by the industry,
 Galaxy may look beyond the insurance markets for financial
support, creating financial instruments which inject money into the
industry that is repaid to a greater or lesser extent in an inverse
relationship with Galaxy’s profits on the line of business. These
instruments will increase Galaxy’s capacity.
[4]

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MA922: Actuarial Risk Management 2 ( May 2016)

(a) Past data

For each direct mailing exercise, the cost of sending the catalogue to each person,
the number of people written to and the number of people buying a product as a
result of being mailed. [1]

For the advertising on Google, the cost of advertising each month in the past and the
number of people buying a product each month as a result of Google.

(Credit for the above point. Alternative: number of clicks on Google for the website,
charge by Google for each click, number of purchases through Google) [1]

For each month:

A The gross turnover (ie total price of products sold)

B The number of products sold

C The proportion of the turnover retained by the company

D The total price refunded to customers

E The total number of products returned

F The total amount of the price refunded which would have been received by the
company

The total number of the customers on the data base

Total direct mailing expenses

Total expenses of advertising on Google

Total salaries

Total other expenses (such as office rents, office equipment)

Items A to F would be spilt by products sold through direct mailing, products sold as
a result of advertising on Google and products bought by customers from the
customer base.

The company’s profit and loss accounts for each of its periods in existence
[.5 per point max 5]

Current data

The annual salaries of the employees and their roles in the company

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The annual office rents

Details of any assets of the company

The company’s plan for taking on staff in the next few years and likely salary
increases

The company’s plan for marketing exercises in the future

Expected annual office rents for the next few years

Details of other expenses expected over the next few years [.5 per point max 3]

[8]

(b) The model will be a projection of the cash flows and profits of the company over
the next 3 years. [1]
The profit over each period might be calculated as:
Gross sales over period
- payments to the clothes manufacturers
- refunds to customers
- direct marketing expenses
- expenses of advertising on Google
- salaries, rents and other expenses
+ interest on assets held by the company [.5 per point max 3]
The model may include the following assumptions:
For each direct mailing exercise assumed, the number of customers mailed, the cost
of sending a catalogue to each person, the proportion of customers buying a
product. [1]
In respect of advertising on Google, the cost of advertising on Google in each month,
the number of customers buying products as a result of the adverts [1]
In respect of the customer base, the proportion of the customer base buying a
product each month. [1]
The average price of products sold [.5]
The average percentage of the price retained by the company [.5]
The average percentage of products returned by the customers [.5]
The 3 preceding assumptions may vary by source of business [.5]
The company payroll each month [.5]
Other expenses each month [.5]
The interest rate on investments held by the company [.5]

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The percentage of profits (if any) payable as dividends to investors [.5]

[8]
[Total 16 marks]

(a) A diversifiable risk is a risk that may be mitigated by diversification. A

systematic risk is that inherently unavoidable in the system in which a
company cooperates and is undiversifiable
[2]
(b) By its choice of an entirely regional presence, SWE has chosen a
system where regional risks are concentrated and systemic.

The significant exposure to the economic health of the region gives rise
to the following risks

 I. Risk to Asset values and income : these will degrade materially if

the local economy collapses – potentially jeopardizing solvency and
profit
 II. Risk to Loan book : if the economy collapses unemployment may
rise and average salaries fall. Current levels of loan repayment and
interest payments may be difficult for borrowers to maintain even, in
the extreme, leading to a profusion of unrecoverable loans –
potentially jeopardizing solvency
 III. Risks to Persistency : if a failing regional economy, policyholders
may have difficulty in meeting premium commitments and a rising
number will seek to convert policies to cash
 IV. Concentration risk in that the above risks will eventuate together,
exacerbating the problems

Other major sources of risk, non economic, may be

 V. Risk of relying on local shareholders : these may have little

expertise and understanding of the business and in the aggregate
insufficiently deep pockets to be the source of future capital.
Moreover, they may tend to clannishness and mutual support
without sufficient criticality of the company.
 VI. Risk of relying on local hiring only : the company may be
engaging less than first rate staff in key positions, it may also be
closing itself from up to date knowledge of industry trends and
opportunities

A systemic side effect of the region being a manufacturing region may

be

 VII. Risk of quality sales loss : if the company’s business and

expertise is around a manufacturing clientele, who may generally
lack financial sophistication, it is risking more upmarket clients

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seeking policies more appropriate (e.g. modern design, lower

mortality) policies from other companies
[5]
Marking notes : I have given more than five and other well argued risks may prove
acceptable too.

(c) Using the numbering above, approaches to my extended list to convert

to diversifiable might be:

 I. Alternatives :
o Diversify by a conscious program of placing new cash flows
predominantly in a wider range of funds
o Over time move purely regional “equity” assets into
segregated unit linked funds available to policyholders in
conjunction with u/l policies ; not the non-UL migrate to a
wider range of investments. Advantage is it can work in
parallel with the diversification approach ; disadvantage is it
will be slow.

 II. Alternatives:
o Diversify by engaging in agreements with other insurers to
share each others’ loan books
o The loan book may be continued but be wrapped into
Collateralised Debt Obligations that are sold as securitized
investments into the national market – where they may be
very attractive in that they have been sourced by a local
expert. Advantage is it will be easier to find hungry banks
than hungry insurers ; disadvantage is lack of in house
expertise and some regulatory suspicions

 III. Alternatives:
o Diversify by reinsuring more, particularly with peer to peer
treaties with other specialist insurers with fundamentally local
books of business. Also by seeking business from outside
the locality through a widened sales and marketing process.
o Guaranteed cash values, if any, should be removed as a
policy feature on new sales. New policies should incorporate
a right to delay payment for up to six months. Commission
recoveries may again be securitized into the wider market or
financial reinsurance put in place. Advantage is it may be
easier to implement than finding the conventional partner the
diversification approach requires ; disadvantage is it will be
slow to dribble through to the in force book

 IV. Treated by the above

 V. Alternatives:

o Diversification is the stated goal of this process and an initial

placement of a small proportion of the shares outside the

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region should be sought as a precursor to the bigger initiative

o Immediately seek to leaven the board of directors with two or
three heavyweights from outside the locality and with
industry expertise. As the need to find non-local money is the
goal, one of these heavyweight positions should be as
chairman. Advantage is that it will send a strong signal to
potential shareholders ; disadvantage it sends a strong
signal to the existing local ones and is, in effect, a non-
monetary diversification.

 VI. Alternatives:
o Diversify through new hires by immediately open up hiring
through national agencies. Most applicants will be local so
the process of diversification will be gradual
o Engage a national consultant to advise on areas where staff
competence needs strengthening ; rehire for these areas on
a national basis. This disruption will have to be faced.
Advantage over diversification is speedier ; disadvantage a
clear message to the regional base.

 VII. Alternatives:
o Diversify by opening new series of policies, geared toward
alternative markets
o Engage a national consultant to advise on sales
opportunities that may currently be missed. The stability of
the current portfolio, and the depth of knowledge of the
current clientele, may make the company an attractive
partner for a reinsurer seeking a new front end for some
business. Such a reinsurer may be a source of cheap advice!
o
[10]
Marking notes : an overdone solution. Will be ready to accept alternative approaches
over the lower (5) range of risks requested. Credit will be given for other reasonable
points.

Question 7

(a) Premiums are set at the beginning of each policy year but the claims
thereafter may vary and inevitably result in profit targets being missed
or exceeded. This experience needs to be understood so that lessons
are learnt and losses are minimalized for future years [2]

(b) Investment returns, expenses incurred and claim levels may all vary
but in a health insurer it is most likely that variations in claims
experience will have the greatest effect on profits. Crudely put, a 10%
overage in each of these areas is likely to reduce profits by,
respectively, around 1%, 1% and 9% of premiums. [3]

(c) It is important to recognize that though the company may only charge

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on the basis of age and gender it will want to monitor the experience in
more depth. The following would be key areas of investigation:

Age Premiums are age dependent

Gender Premiums are gender dependent
Duration Monitoring whether the aggregate premium is
leading to significant cross subsidies between
policy generations
Claim type Monitoring whether the charging basis for each
claim type is appropriate ; also monitoring whether
the scale cost for each claim is accurate or should
be challenged to the regulator
Claim delay Any delays in notification should be monitored for
the purpose of setting up tail liabilities and IBNR
Occupation Looking for differences in claim levels by direct
occupational factors (e.g. asbestosis) or indirect
(e.g, malnutrition)
Income/ Looking for differences according to wealth status
wealth level
Region Regional variations may be expected, sometimes
allied to occupation or income levels, and
analyzing the experience may lead to favouring or
otherwise regional areas for sales
Sales source Investigation by type of sale, may indicate
particularly profitable or unprofitable channels and
may even be drilled down to agent level if there is
suspicion of targeting or misselling practices.

[5]
(d) Existing companies will be obliged to maintain profitability to meet the
rising claims levels since initial selection of each policyholder. Healthier
policyholders will be subsidizing unhealthier ones and will exit their
policy on renewal to obtain cheaper new policies elsewhere. Inevitably,
new companies will arise who can provide initially cheaper select
policies and older companies will be left with a diminishing and
increasingly less healthy portfolio. This indicates a failure of the
country’s law as it encourages an instability among the product
providers. [2]
(e) Ultimate profit on a group of policies is the profit of that group in the
aggregate once the group has run its entire course and no policy
remains in force. Annual profit is the calculated profit on the group in
one year based on the experience of that year.

Ultimate profit is important as annual profits may vary (both from

experience and from design) and the efficacy of the pricing will not be
fully known until closure of the book.

Annual profit is important because it aggregates to the profit line of the

company in that year. Shareholders will be expecting the profits to be in

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line with their target expectations. It is also an important indicator of the

way profits are progressing on their way to the ultimate knowledge.
[3]
(f) The dominant part of the annual profit will be claims profit or loss.
Health claims, significantly more than life claims or general insurance
claims, tend to be affected by the economy so fluctuations in the claims
experience can be substantial.

A secondary, but major, component of the annual profit is profit on

expense loadings. Health claims are expensive to handle and each
policy may have several claims in any one year. In so far as the
number of claims is variable (see the paragraph above) so the cost of
claims is also variable and can impact profits noticeably.

A tertiary component is investment return. It is probable that this capital

will be invested in stable assets, e.g. short term high quality bonds, to
maintain variances in return at a low level [3]

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